Inflation Targeting and Exchange Rate Fluctuations in Australia

Chris Ryan and Christopher Thompson
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Chris Ryan: Reserve Bank of Australia
Christopher Thompson: Reserve Bank of Australia

RBA Research Discussion Papers from Reserve Bank of Australia

Abstract: Several recent papers have explored the possibility that inflation-targeting central banks in small open economies pay too much attention to exchange rate fluctuations; changing short-term interest rates in response to fluctuations that have transient effects on inflation could be counterproductive. Accordingly, we investigate whether the Reserve Bank of Australia, while ultimately concerned with aggregate inflation and output, should set short-term interest rates on the basis of expected inflation in the non-tradeable sector or go even further and react directly to expected wage pressures in that sector’s labour market. Our results indicate that there are no clear gains to be had from responding only to measures of inflation which abstract from temporary exchange rate fluctuations. The variability of inflation and output would be at least as great as under the current framework, while the shocks that have typically hit the Australian economy over the past couple of decades are such that interest rates would be no less variable than under the current inflation-targeting framework. We attribute these findings to the forward-looking nature of the current inflation-targeting framework, whereby exchange rate shocks are ignored in the setting of policy if they are expected to have only a temporary impact on inflation.

Keywords: exchange rates; inflation targeting; macroeconomic model; monetary policy rules; open economy (search for similar items in EconPapers)
JEL-codes: E52 E58 E61 F41 (search for similar items in EconPapers)
Date: 2000-09
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Citations: View citations in EconPapers (16)

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Persistent link: https://EconPapers.repec.org/RePEc:rba:rbardp:rdp2000-06

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